A Reckoning with Wall Street

Mainstream economists claim people's earnings reflect their productivity. That means the top executives who earn tens of millions of dollars are worth hundreds of times more than the ordinary mortals who measure their pay in the tens of thousands.

As one financial giant after another tumbles into bankruptcy, it is getting hard to accept the standard economist's view of the world. Does anyone know what the top executives at Bear Stearns, Lehman Brothers, IndyMac, Fannie Mae, and Freddie Mac and the rest did to justify the tens of millions of dollars they each pocketed? Surely there were people who would have driven these companies into bankruptcy for less pay.

The developments in the financial sector over the last year have revealed a level of incompetence and corruption that exceeds the strongest charges of Wall Street's critics. Did these multi-millionaires really think real estate prices would just keep rising forever? Did they never consider the possibility that the housing market was experiencing a bubble? Did they not know a collapsing bubble would send mortgage default rates through the roof and lead to huge losses on mortgage backed securities and derivative assets? Apparently, the highly paid executives at these firms never considered such possibilities. Their incompetence drove their firms into ruin. That's bad news for the shareholders.

Unfortunately, the country as a whole is also paying an enormous price for the executives' incompetence. They were the ones that supplied the capital that drove the house bubble. If banks did not give mortgages to people buying hugely overvalued homes, the bubble could never have grown to such dangerous proportions.

Had it not been for the incompetence of the Wall Street crew, millions of workers would not be worried about losing their job due to the recession. Millions of homeowners would not be fearing foreclosure. And ten of millions of homeowners would not be seeing their home equity disappear before their eyes. As a result of their greed and incompetence the Wall Street crew has subjected the country to the largest financial crisis since the Great Depression.

This damage cannot be easily reversed now, but we can still try to reap some benefits. Federal Reserve Board chairman Alan Greenspan deserves much of the blame. He was grossly negligent in allowing both the stock and housing bubbles to grow unchecked. He decided to just let the bubbles run their course, expecting to pick up the pieces after they burst.

As is now apparent, this policy leads to disastrous outcomes. The Fed should have done everything in its power to prevent these bubbles, especially the housing bubble, from growing to such dangerous levels.

When families spend $200,000 too much to buy a home at a bubble-inflated price, or borrow based on home equity that disappears in a crash, they will never be able to recover. Millions of families are in this situation now.

Beyond ensuring that the Fed takes its responsibilities seriously, we also have an unprecedented opportunity to rein in the outrageous paychecks that the Wall Street executives write for themselves.

The Wall Street banks are dependent on the Fed as they never have been before. They are borrowing record amounts of money from the Fed at below market interest rates. The Fed has also agreed to accept mortgage-backed securities of questionable quality as collateral, and now even shares of stock.

Arguably this is good policy, since the Fed does not want to see more banks collapse and risk a cascade of bank defaults, as we had in the Great Depression. However, the Fed can make some serious demands as a quid pro quo for its largess. Specifically, it can insist on an absolute cap of $2 million in total compensation (that means bonuses, options, perks, everything) for any employee of the banks taking advantage of the Fed's largess.

This would be an enormous pay cut for the Wall Street elite, but they will have little choice. The executives of any bank that refuses the deal and subsequently collapses will likely be sued by their shareholders and face personal liability. Not many executives will welcome this prospect.

Some executives might quit rather than take such a large cut in pay. But losing executives who have pushed their companies near bankruptcy is no loss.

If the Fed can succeed in pushing down Wall Street pay, that could have a ripple effect on other sectors. Wall Street was setting the pace on the way up, justifying paychecks in the tens of millions of dollars in other industries as well. If Wall Street pay can be reined in, that can be an important first step in reining in excessive pay across the board. This in turn would be a huge factor in reversing the growth of inequality over the last three decades. If that could be accomplished, this crisis would have led to at least one very positive development.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.